Counterfactual Analysis

of these moments. The model captures the relative size of a large informal firm at the 95th percentile. Among small formal firms, the model prediction deviates one or two standard deviations from the real data.

The model predicts a segmented trade structure whereby formal firms purchase 80 percent of their inputs from formal suppliers, while informal firms purchase 43 percent of their inputs from formal suppliers. The share of sales to formal buyers is 48 percent and 28 percent in the model for formal and informal firms, respectively, compared with 48 percent and 16 percent in the real data. The model generally captures the trade structure of formal firms, but it overestimates informal sector trade with formal partners.

IDENTIFYING THE TYPES OF INFORMAL FIRMS

The existence of various perspectives on the informal sector implies that different sorts of behavior are embraced across informal firms in response to tax reforms. This subsection discusses a perspective that explains most accurately the response of informal firms to VAT adoption.

Informal firms may be divided into three types: reservoir, parasite, and unproductive informal firms. Reservoir firms become formal after all tax burdens (VAT and corporate taxes) are removed. Parasite firms can survive as formal firms if all tax burdens are removed, but they nonetheless remain informal. Unproductive-type firms can survive only as informal firms. If the tax rate falls to zero, the present value of formal status is negative, but the present value of informal status is positive.

If tax rates drop to zero, around 3.50 percent (downstream) and 0.03 percent (upstream) of informal firms will formalize (figure 3.6). Only 5.10 percent and 0.25 percent of informal firms can survive as formal firms (but choose not to) in downstream and upstream industries, respectively. Unproductive firms make up the majority of informal firms and are too unproductive to formalize even after the tax burden is removed, that is, if tax rates drop to zero.

The availability of the estimated parameters allows the model to be used to compare the VAT and the cascading sales tax at any tax rate. For the analysis, the tax rate is set at 7.5 percent, which is consistent with the statutory sales tax rate in the state of West Bengal. Two other scenarios—VAT rates of 9.5 percent and 10.1 percent—are also considered, the first because it generates the same number of formal firms, and the latter because it generates the same level of tax revenue after VAT adoption. Respectively, these are the informality-neutral scenario and the revenue-neutral scenario.